Strategy: Key Concepts and Open Questions

• As in finance, the goal of the firm is value maximization

• “Strategy” may be defined as the way the firm deploys its resources and capabilities within its environment to maximize its value

• The strategy literature typically takes a less quantitative approach than finance or industrial organization; analyses are more descriptive and somewhat less analytical

Key Concerns

Key concerns:

1. Industry Attractiveness: Which industries should the firm be in?

2. Competitive Advantage: How should the firm compete? What does it have that its competitors, suppliers, buyers, potential entrants, and complementors do not?

3. Boundaries of the Firm: What should the firm do, how large should it be (make vs. buy; scope)

4. Internal Organization: How should the firm organize its structure and systems internally?

Relation to Other Fields

• The strategy literature borrows heavily from finance, industrial organization, and the theory of the firm

• Value maximization and the associate computations (after-tax cash flows, net present values) are key concepts from finance

• The frameworks for analyzing industry attractiveness emerged from industrial organization

• Work on the boundaries of the firm follows the theory of the firm; transaction costs are referred to frequently in the strategy literature

Relation to Other Fields

• The concept of competitive advantage is directly related to the notions of “positive economic profits” in economics and “profits in excess of the opportunity cost of capital” in finance

• Competitive advantage can be defined as: A firm possesses a competitive advantage when it earns a persistently higher rate of profit than its competitors

Industry Attractiveness

Porter Competitive Strategy (1980) The Five Forces Framework for Industry Analysis:

 

Buyers

 

Entrants Competitors Substitutes

 

Suppliers

The Five Forces Framework

The Five Forces Framework is primarily used to assess the profitability of different industries, not the profitability of specific firms, but it is useful for both

 Estimates vary, but most suggest that 10 to 20% of the

variation in firm profitability is accounted for by the industries firms operate in

Rivalry among existing firms is the main focus of industrial organization and strategy, but the other forces cannot be ignored

Applying the Framework

• Strategy texts provide long lists of factors that affect industry profitability in the five forces framework

• For any particular analysis, it is useful to focus on a small number of key factors determined on a case-by-case basis

• Most of the factors are based on findings in the industrial organization literature

• For example, the main factors that affect the threat of entry and the threat from substitutes are barriers to entry and the cross-price elasticities of demand

Factors

Factors that Affect Rivalry Between Existing Competitors: 1. Brand Identity2. Concentration: the number of competitors and their

variation in size3. Fixed Costs4. Industry Growth5. Intermittent Overcapacity6. Product Differentiation7. Switching Costs

Factors that Affect the Bargaining Power of Buyers 1. Ability to Backward Integrate2. Buyer Concentration 3. Information4. Price-sensitivity5. Product Differentiation6. Switching Costs Factors that Affect the Bargaining Power of Suppliers 1. Differentiation of Inputs2. Impact of Inputs on Cost or Differentiation3. Size of Purchase4. Supplier Concentration5. Switching Costs6. Threat of Forward/Backward Integration

The Five Forces Framework is incomplete because it does not recognize the role of allies, collaborators, and other partners

 Brandenburger and Nalebuff Coopetition (1996)  The Value Net adds “Complementors”: 

Customers Competitors The Firm Complementors 

Suppliers Complementors are the mirror image of competitors: they increasebuyers’ willingness to pay for the firm’s products and decrease the

price that suppliers require for their inputs 

Doctors: Doctors influence the success of pharmaceutical products byprescribing drugs, but they are not buyers Intel/Microsoft: Microsoft’s software runs on computers equipped withIntel microprocessors, and it’s more valuable when combined withbetter processors Drug/Biotech Allies: Small biotechnology companies form allianceswith large drug companies to develop and market products Any given firm may play multiple roles in the value net – this isparticularly important for large firms. For example, in its relationshipwith small software companies Microsoft may be a supplier, potential

competitor, complementor, and buyer 

Examples of Complementors:

Dynamics

Key features of the environment change over time

1. Buyers and their needs

2. Regulations

3. Relationships between players

4. Suppliers and their products

5. Technology

Competitive Advantage is Temporary

Ghemawat Commitment (1991) analyzes return on investment (ROI) reported over a ten-year period by 692 business units

 Splitting the sample into two equally sized groups based on ROI

revealed that the top group’s ROI in year 1 was 39% and the bottom group’s ROI in year 1 was 3%

 After ten years over 90% of the 36 point gap between the two

groups was eliminated

Thus, most of competitive advantage depends on a temporary firm or business unit effect

Industry vs. Firm Effects

McGahan (.) assesses the relative importance of the following types of effects in explaining variation in firm profitability:

1. Permanent industry effects: 11%

2. Temporary industry effects: insignificant

3. Permanent firm effects: 24%

4. Temporary firm effects: 57%

Her study uses Compustat, which is not as disaggregated as possible, but the results still suggest that firm effects are more important

Firm Effects: Resources and Capabilities

• The basic finding that industry effects appear to account for little of the variation in firm and business unit profitability has led strategy researchers to focus more on firm effects

• Achieving superior profitability within an industry is emphasized more than finding profitable industries

• This has led to increasing focus on firm-level resources and capabilities

Resources and Capabilities

• Strategy can be oriented around demand or internal resources and capabilities

• In environments with rapid change, it is better to formulate strategies around resources and capabilities

• For example, when PCs began to replace typewriters in the early 1980s, typewriter firms that attempted to follow their customers by trying to enter the PC market generally failed

• Typewriter firms that pursued other products where their existing skills could be useful were more successful (small electronic appliances, etc.)

Resources and Capabilities

Establishing a competitive advantage is concerned with formulating and implementing a strategy that recognizes and exploits the unique features of each firm

Basic units of analysis are the resources of each firm:

Items of capital equipment, skills of individual employees, patents, brands, and so on

Resources work together to create capabilities, which are basically “what the firm is good at”

Establishing and Sustaining Competitive Advantage

• In order to establish a competitive advantage, a resource or capability must be scarce; if every firm can acquire the resource or capability then the outcome is much like perfect competition

• In order to sustain a competitive advantage, their must be barriers to imitation

• Are the resources or capabilities transferable (can they be traded or spread through employee mobility?)? Can they be replicated?

• Intangible resources become important: brands, reputation

• Plants and equipment and even patents become obsolete relatively quickly

• Capabilities based on complex organizational routines are less vulnerable to imitation (like FedEx’s next-day delivery service)

Emergence of Competitive Advantage

• Dynamics are important for explaining the emergence of competitive advantage

• Some firms have greater innovative capabilities• Some firms are better able to respond to change, either

because of intrinsic change management capabilities or because their resources or capabilities are well-suited for the particular type of change occurring

• External sources of change include changing tastes, prices, and technological change

• Competitive advantages emerge when firms innovate or benefit from external change

First Mover Advantages

First movers accept the risk that the market may not materialize, but if the market materializes the first mover may acquire resources and capabilities:

1. Resources like store locations may be scarce

2. A reputational asset is created with suppliers and buyers

3. Where standardization is an issue, the first mover may be able to set the standard

4. The first mover can learn by doing and move down the learning curve ahead of followers

Industry Evolution and the Life Cycle

• Competition is a dynamic process in which firms attempt to obtain competitive advantages only to see them eroded by imitation, innovation, and external change

• The industry environment is reshaped by the forces of competition

• The industry life cycle is a common pattern of industry development: industries can be classified according to their stage, and we can determine which strategies are appropriate in each stage

Product Life Cycles

• Products are born, their sales grow, they reach maturity, they go into decline, and they eventually disappear

• The industry life cycle follows the product life cycle and thus depends on how broadly defined the product is

• 64-bit video games have a relatively short life cycle but video games in general have a long life cycle

• Strategy researchers generally divide the life cycle into four stages: introduction, growth, maturity, and decline

• Demand growth and the production and diffusion of knowledge varies over the life cycle

Demand Growth

• Think of an S-shaped growth curve• In the introduction stage, quality and sales are low and

costs and prices are relatively high; customers tend to be high-income innovation oriented risk accepting individuals

• In the growth stage, quality improves, costs and prices come down and sales increase dramatically; the product obtains mass market appeal

• In the maturity stage market saturation increases and increasingly demand is replacement demand

• In the decline stage the industry is threatened by a replacement

Diffusion of Knowledge

• Knowledge diffusion drives the industry’s evolution

• In the introduction stage, there may be no clear standard and product improvements and changes occur rapidly

• Standardization often leads to the growth stage; mass market appeal requires a product that is unlikely to become obsolete quickly

• In the growth stage, obtaining scale and access to distribution is key

• Product and process innovation depend on technological opportunities and may persist or vary throughout the life cycle, but in the maturity stage there may be a shift to process innovation if opportunities for further product improvements diminish

• In the decline stage the orderly exit of capacity is important to prevent price wars; industry consolidation is critical

Key Open Questions

• Understanding resource, capability, and strategic heterogeneity in dynamic environments could use much additional work

• In depth studies of particular firms in their industry context could provide additional insights about how particular resources, capabilities, and strategies are advantageous at different points in the life cycle

• For example, I have a working paper that uses a simple model to study mergers in declining industries

• Few other studies have even bothered to investigate mergers in this environment, although consolidation is a critical strategic objective

Key Open Questions

• The key insights from the strategy field have not been fully incorporated into industrial organization

• Dynamic models of industry evolution should incorporate greater differences between firms in terms of their resources, capabilities, and strategies

• Models should be consistent with the result that the vast majority of profitability depends on firm effects and that most of profitability is transitory

• Key resources, capabilities, and strategies should also affect firm valuations; studies of stock prices and returns can investigate these relationships